If you’re interested in building wealth through real estate, you might be wondering what it takes to buy rental property. Even in a challenging real estate market, rental property remains a potentially viable investment vehicle. Read on for advice about buying it, including how to get started, how to make money, and whether or not being a landlord is the right choice for you. And if you decide against buying rental property, we’ll discuss other ways to invest in real estate.
7 Tips for Buying Rental Property
Successfully buying rental property goes beyond the purchase. Understanding the business you’re getting into is essential before you spend your hard-earned money on rental property. Here are seven tips for buying rental property.
1. Find a great agent
Real estate investors with an accomplished agent have a distinct advantage over the competition. Agents may be able to find deals for you, help with complicated contracts, and negotiate effectively.
“Not all agents work the same,” says David Greene, host of the BiggerPockets podcast and author of Pillars of Wealth: How to Make, Save, and Invest Your Money to Achieve Financial Freedom.
“When choosing your agent, there are definitely things to start off asking them,” he says. These may include:
- How many investment properties do you own?
- Do you have contractors or handymen in the area who can fix up investment properties?
- Do you know property managers who can advise you on the properties?
- Do you know loan officers that specialize in investment properties?
“The goal is to find an agent who is well versed in the type of real estate you want to buy,” says Greene. “This is more complicated than just finding a local realtor who sells homes in your area.”
2. Educate yourself as much as possible
You’ll want some expertise as you enter the rental world. Some things you may want to start learning about include:
- Fair housing laws.
- Local codes and ordinances.
- State and local eviction laws.
- Taxes.
- Depreciation.
- Market analysis.
- Basic repair and maintenance.
It may sound overwhelming at first, but just dive right in and learn one thing at a time.
3. Start with your own home
Many people sell their homes and use the proceeds to buy the next home. It’s also possible that you could keep your first home, rent it out, and then buy your next home.
If you’re thinking about going in this direction, take a look at your budget and have a talk with your lender about how you can buy your next property without selling your current home. It might take some adjustments to your expectations, and you may want to start using a budgeting tool such as Quicken to help with your goals.
4. Consider house hacking
When you buy a property with multiple units, you can live in one and rent out the others. Depending on the numbers, it may be possible to get your living expenses paid for by the other rental units. Having your housing paid by the other tenants is where the term “house hacking” comes from.
It’s a good entry into the real estate market, because you can qualify for owner-occupied financing by living in one of the units. This means both lower interest rates and lower down payments.
5. Learn to analyze properties and markets for profit
There are multiple ways to assess a property for its income and profit potential. Here are a few:
- Return on investment (ROI). Calculating the ROI tells you how much you’ll earn relative to how much money you’ll invest. The formula looks like this: net profit ÷ cost of investment x 100 = ROI. For example, a rental that earns $10,000 in profit per year with a total investment of $300,000 would be expressed like this: ($10,000 ÷ $300,000) x 100 = 3.33%. Of course, that’s per year; you’ll earn much more over time.
- Cap rate. The capitalization (cap) rate is the net operating income for the year divided by the market value. If your rental makes $10,000 a year and the value is $400,000, then your cap rate would be $10,000 ÷ $400,000 = 2.5%.
- 1% rule. The 1% rule states that the monthly rents must equal 1% of the total purchase price. If you purchased a property for $200,000, rent should be above $2,000. Keep in mind that it’s just a guideline and nearly impossible to meet for high-cost and high-growth areas.
6. Expand your financing options
There’s more than one way to buy a rental property. Investors have multiple methods and sources for financing rental property, such as:
- Buy an owner-occupied property and live in one of the units.
- Qualify with rental income from a property that has more than one unit.
- Use a home equity line of credit (HELOC) on your primary residence to buy an investment property.
- Use financing from private lending.
- Buy with a conventional investor mortgage that may require around a 20% down payment.
- Use a hard money loan, which comes from a private lender and is secured with collateral, often real estate, for temporary financing.
- Buy with cash.
- Work with seller-financed properties.
Different situations call for a variety of lending solutions.
7. Consider alternative ways to invest in rental property
If you’re reconsidering buying rental property, there are other avenues you can take to invest in real estate.
- Form a partnership. The right partnership can expand your options, divide costs, and limit your risk when it comes to buying rental property.
- Buy a REIT. Individuals can invest in real estate through a real estate investment trust (REIT). This is a type of investment where you buy into a fraction of a large real estate portfolio. You don’t have to manage the investment, nor do you need a large down payment. You’ll see a smaller profit, but it’s a more passive investment than buying rental property outright.
- Consider fractional ownership. With fractional ownership, you share ownership–both the cost and rights–with a group of people. You each have a deed, so it’s different from a timesharing investment.
- Find a real estate syndication. Real estate syndication allows you to invest in a larger project without having to manage it.
Is rental property the right choice?
Buying rental property and becoming a landlord is not for everyone. Once you’ve funded the purchase, your real job begins, and it can be stressful.
Even when you employ a professional management company, there are a lot of things that make buying rental property undesirable. Here are a few to keep in mind.
Management is costly
While handing over the reins to a professional management company might seem like a good idea, you should be aware that they may charge between 8% and 12% of the rent collected per month. This amount often won’t include new leasing fees, cleaning, repair, maintenance, or eviction expenses.
Tenant issues can be overwhelming
Experienced landlords and property managers have seen it all. Fires, floods, drugs, trash, animal issues, violence, neighbor issues, property damages, missed rent payments, and everything in between. They’ve also seen tenants who pay on time and keep the property clean and attractive.
If you’re in it for the long haul, you have to be tough, and you have to know your numbers. It can be a real challenge to make money in real estate.
How to become a landlord and buy your first rental property in five steps
Once you’ve done your homework, here are five actionable steps for buying rental property.
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After you’ve bought your property, your journey as an owner and landlord begins. Start putting processes in place to help the business run smoothly.
How to make money in rentals
With rental property you’re looking to make money in one of two ways.
Cash flow
Cash flow is how much money is left over after you’ve paid your expenses. If your rent is $1,500, and your expenses are $1,000, your cash flow would be $500. Included in calculating cash flow are such variables as acquisition costs, ongoing expenses, and rental market rates.
Appreciation
Appreciation is the increase in the value of your property. Certain markets see better price appreciation than others.
Ideally, you’ll make money in real estate through a combination of both cash flow and price appreciation–but it can be difficult. “In today's market more people than ever are looking to make money in real estate, specifically through rental properties,” says Greene. “The challenge is, very few rental properties cash flow positively now that interest rates have increased, but property prices are still high. The key in today's market is making money in ways other investors don't see. Prudent investors look for ways to add value to the properties they buy.”
And what would those ways be? “As simple as making small properties bigger, or as complex as adding additional units to properties to increase the total revenue they can bring in,” says Greene. “The smart money doesn't see the property for what it is now; it sees it for how it would best be used.”
Greene sums it up this way: “Rental investors need to take a long-term and intelligent dive into what, when, and where to buy real estate. Choosing the right markets—with growing demand and constricted supply—can lead to huge future returns, even if they don't look appealing at first sight.”
Buying rental property: risks and rewards
Rental property comes with a lot of risks, but there are also plenty of rewards involved if you get the right property and manage it properly.
Rewards
- Someone else is paying to build your wealth.
- Properties can appreciate.
- Properties can create a positive cash flow.
- The tax code is favorable for rental properties.
- There exists a strong need for rentals.
Risks
- Entry costs can be high.
- Maintenance costs are high.
- The property needs to be managed, whether by you or a professional management company.
- It’s pretty stressful, even if you don’t manage it yourself.
- Property value can decline.
- Renters can destroy your property.
- Cities can create laws that may affect your property (outlawing Airbnbs, rezoning an area, building-code changes, etc.).
Time Stamp: Becoming a landlord is not for everyone, but it can be lucrative.
Buying rental property can be tough, and it may not be all that rewarding. Not everyone is cut out to be a landlord. That said, it can also be a life-changing way to build wealth. Determination can make or break you. If you do your due diligence, create a plan, and keep to it, you’ll find a way to make rental property pay.
Frequently asked questions (FAQs)
How do you buy a second rental property?
It may be possible to use equity from your first rental property to help pay for a second. A cash-out refinance and a HELOC are popular options. You can also go the traditional route and put down additional money on a rental property with an investment property mortgage. If you want to sell property to buy a second rental, a mortgage trade-in from a lender such as Calque is another option.
What is a good capitalization rate for a rental property?
The best answer to this question, of course, is, “It depends.” Generally speaking, the higher the cap rate, the higher your risk and rewards are. It’s variable, but vacation rental management company Vacasa says rates between 3% and 8% are normal, depending on your area. This number doesn’t include price appreciation.
How do you calculate depreciation on a rental property?
As there are several ways to calculate depreciation on a rental property, there’s no short answer to this question. You may want to hand it over to your accountant. Still, the most common method is to use straight-line depreciation over 27.5 years. This means you’ll depreciate the property evenly over 27.5 years.
To do this, take the cost basis (how much you paid to acquire the property) and divide that by 27.5. For example, if your property cost $500,000, divide that by 27.5. The result is $18,181.82, which is the amount that will go on your taxes. Note: Be sure to calculate depreciation based on how much you spent to acquire the property and not its current market value.
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